Episode 29: How The Government Will Pay To Lower The Risk In Your Business

Announcer:     This is The WealthAbility™ Show with Tom Wheelwright. Way more money, way less taxes.

Tom Wheelwright:      Welcome to The WealthAbility™ Show, where we're always discovering how to make way more money while paying way less taxes. Hi, this is Tom Wheelwright, your host, founder and CEO of WealthAbility™. What if you could lower the risks in your business and have the government pay for lowering the risk? Today we're going to discuss one of the most amazing incentives in the tax law. As you all know, the tax law is a series of incentives, primarily for business owners and investors. Business owners and investors have a lot of risks that we really self-insure. In other words, we don't have insurance to cover these risks, and today we're going to talk about how to get insurance to cover those risks and get a tax deduction for covering the risks without being out-of-pocket for the insurance.

I know it sounds too good to be true. It's one of those too-good-to-be-true things, but if you are a successful business owner or a successful investor, particularly a successful real estate investor, then this show is an absolute must for you, and I have a guest on the show today, one of my good friends and seriously, I think the best at explaining this particular tax incentive. He's a specialist in this tax incentive. There are some tax incentives like research and development credits, cost segregation, there's some that require a specialist. Well, this is one of these, so today we're going to welcome my good friend Chuck Spitzer, who is an expert in this area called captive insurance. Chuck, welcome to the show.

Chuck Spitzer: Thanks, Tom. Appreciate the opportunity to visit with you today.

Tom Wheelwright:      Hey, so Chuck, just give our listeners … I know some of them know who you are, but give our listeners a little bit of your background and basically what you do.

Chuck Spitzer: Excellent, I'll be happy to do that. Yes, by background and by training I'm a CPA. I spent many years in the public accounting arena, and I also had a lot of experience in insurance. I guess about 10 years ago I really became very interested in this captive insurance idea. So I started exploring it, and about eight years ago I founded the firm Captive Insurance Group, and the sole purpose of our firm is to first determine whether or not a company qualifies to adopt a captive insurance program from a economic viewpoint and from a risk viewpoint.

So your introduction of having insurance and insuring risks in your business that the government helps pay for through the tax incentives, is exactly what our firm does. We currently manage about 80 of these insurance companies for clients all across the United States.

Tom Wheelwright:      So Chuck, basically, before we actually describe how the captive insurance company works, what are some of the risks that you find typically that business owners and investors are not insuring because if they were to insure them the premiums would be too high, and that they can insure with their own insurance company through a captive insurance policy?

Chuck Spitzer: Sure. There are a number of them. We have more than 40 lines of coverage, but sometimes, Tom, it's a matter of insuring things that are excluded from the commercial insurance coverage that a client has in place. So we analyze how they are currently insured to see where there are exclusions and gaps, as well as what you described, which is other kinds of risks that they might have that they cannot go to the market and buy coverage for.

That can include things like the risk of the loss of a key supplier. Let's say that, for example, we have a client down in Florida who relies on one supplier for two major components that they use in their manufacturing process. If they lost that supplier they would have to figure out, how are we going to replace this supplier, which would likely be at a higher cost. It may even mean that they have to develop a means of manufacturing those products themselves. So the risk of additional expense and/or loss of revenue as a result, that's one example.

It can be other things like reputational risk. More and more clients find themselves in situations where they are being criticized in social media or elsewhere on the internet, and sometimes it's just someone being mean and saying things about them that are not true, but nonetheless they have to somehow mitigate that, which sometimes incurs legal cost to do that. Or we had a client who had a real reputational risk problem and had to engage a public relations firm to help them overcome that. It can be things like that.

It can be the risk of the loss of a key person that you might have in your business. Administrative action risk. Maybe the OSHA comes in and fines a manufacturing company because of something that they find that they're doing, and so the client then incurs costs maybe to defend themselves, as well as pay a fine. Those are things that can be insured for.

Product recall. We have some clients also that do business in other parts of the world, and they have true political risk in those countries that they do business in. It can be other things just as simple as a large physician practice who maybe wants an extra layer of coverage on their professional liability. So every situation is different, but that's a few examples of some of the things that we can do.

Tom Wheelwright:      Actually, social media risk is one I hadn't thought of. That's a real risk. I know in our business, everybody knows, we're not the least expensive CPA firm or network of CPA firms in the world, and so we get people just hammering us from time to time on social media just because we're expensive. And I'm going, “That's like hammering Mercedes because their cars are more expensive than Toyota,” which makes no sense but it happens. I think the social media risk, that's a fascinating one.

Let's talk about, pretty much what's happening here, and I'm going to kind of describe it, and Chuck, you can correct me if I make a misstep anywhere here 

Chuck Spitzer: Sure.

Tom Wheelwright:      Here's how I see captive insurance. You have a business, or you have, whether it's real estate investing, whether it's like you said, a physician's office, manufacturing facility, whatever your business is. You've got all these risks, some of which Chuck mentioned, that you're not currently able to insure. So you form, or rather Chuck forms, an insurance company, and it's an insurance company that you own. You own this insurance company, so your business pays the premium to your insurance company. Now here's the little magic. There is a special provision, this is as an incentive in the tax law, that says that if you're a small captive insurance company then the premiums, while deductible to the business, are not taxable to the insurance company.

Now, that's a little bit of magic. Meaning you get a deduction, but it's not taxable. It's frankly a little bit like putting money into an IRA or 401(k) in that you get a deduction, and your IRA or 401(k) does not have to pick that up as income. So a captive insurance company works the same way. The difference becomes when you take that money out.

So let's say down the road, several years down the road you sell your business. You have no need for the captive. At that point you may liquidate your captive insurance company. Well, when you liquidate your captive insurance company, it is now, instead of being taxed at a higher tax rate like an IRA or a 401(k) would be, it's actually taxed at a lower tax rate because it's taxed at capital gains rates.

Okay, that's current taxation of course. Tax laws change all the time, but that is currently how it is handled, and that's currently how the tax situation works. Then the challenge is, okay so you've got a single insurance company. Chuck, first of all let me check in with you. Did I explain that okay?

Chuck Spitzer: Yes, absolutely, and you might just mention that the maximum annually in premium that is exempt under this code section that you mentioned, the 831(b), currently is $2.3 million in premium. Now, there are not many companies that have the risks to qualify for that amount of premium, but yes, your explanation of that is exactly right. It's that arbitrage that exists between the marginal tax rate that the client is obtaining as a deduction and the rate at which they can take the money out subsequently, which is at a lower rate, a capital gains rate.

Tom Wheelwright:      Right, so we actually get … when we talk about tax savings, we talk about five ways to reduce your taxes. One of them is conversion, which is converting income from a higher tax rate to a lower tax rate type of income. That's what this is, this is conversion. But another one is deferral, postponing the tax. We also get deferral here, because as long as you have that captive up and running, you're not paying that capital gains tax. That gets deferred, so we get two types of tax benefits. We get deferral and we get conversion, so that's very important.

Okay, so Chuck, then the big question is, well wait a minute, if I'm just paying myself, how is that insurance? Can you explain the concept of a pool for insurance purposes?

Chuck Spitzer: Sure. Let me back up one step, Tom, and just say that a very important part of putting together a captive insurance program is the use of an independent actuarial firm who goes through the underwriting process and also makes a determination of what the premiums are actually going to be for each of these areas of risk. Now, in our program, we get the client way down the road before we ever engage an actuary, but that is an important aspect of putting these into place so that they work as they're supposed to.

Tom Wheelwright:      Yeah, I've got to say, I've had the experience, I'm sure you've seen a lot more than I have, but I've seen captive insurance policies where the premiums were like, really? You're paying that much of a premium for that risk? I actually had a client who had a captive insurance provider, not Chuck by the way, who was having them pay $40,000 a year to manage IRS audit risk. And this wasn't the tax risk, this was actually managing the fee risk of an IRS audit. Well, I told the client, I said, “Look, I'll tell you what. You pay me that. I'll actually take $10,000 less than that. You can pay me that, and I will cover any audit you ever get.” Because I'm going, “That is just not a realistic premium. I mean, it's not a real risk.”

So when Chuck says that you need a good actuary, he's not kidding. This is very important. One thing everybody needs, please understand this, folks, is that you have to dot your I's and cross your T's. Any time you have a tax benefit that is this great, you must be perfect. And on top of that, you're not just talking about the tax regulators, not just the IRS, you're also talking about insurance regulators. Just be sure that you've got, this is one of those places where having a great team is going to be more important than anything else you do when it comes to this insurance. So thanks for bringing up that actuarial issue, Chuck.

Chuck Spitzer: Sure, absolutely. I probably got us off track there. What exactly were we talking about?

Tom Wheelwright:      We were talking about pool. We were talking about pooling the risk.

Chuck Spitzer: Oh, the pool, yes. Excellent. How does it qualify as insurance? Well, a basic premise of a captive insurance arrangement, and this is true for 99% of every small captive that's ever been created, is that in order to qualify for this tax benefit under Code section 831(b), there are certain aspects of the Code that you have to follow. There were a series of Revenue Rulings that were issued a number of years ago, and the essence of that said that if you had a captive insurance company, you could not have as the only insured of that captive insurance company just your operating company.

The way to satisfy that part of the Code section was for the insurance company that we would create for you, for your client, will participate in a reinsurance risk pooling arrangement that allows for risk diversification, risk transfer, and risk shifting. Those are kind of the key words that the IRS is looking for in terms of making sure that you truly have a diversification of risk.

When the client's insurance company participates in this risk pooling arrangement, what that means is, is that their insurance company is going to take a little piece of risk of all of the other insurance companies that participate in this reinsurance risk pooling arrangement. And at the same time, the other insurance companies are going to take a piece of that client's insurance company's risk.

So if you have a million dollar claim in the client's operating business, the client's insurance company is going to absorb a portion of that claim, and then a greater portion of that claim, like in the case of a million dollar claim, in most cases, 750,000 in this example would be absorbed by all of the other members that are in this reinsurance risk pool. So it truly is a risk sharing arrangement, and it's a very important aspect of the proper construct of a captive insurance arrangement that's going to qualify under section 831(b) as this risk pooling.

Tom Wheelwright:      Yes, there was a large CPA firm, I will not mention which one, that got in a lot of trouble, actually, a number of years ago, several years ago, because they were not pooling the risk. And that's when captives kind of fell out of favor, because the IRS went after this big CPA firm and their clients, and then people just got scared about captives. And what's happened is, is that it's actually been good for the industry, because it means that we've got better rules. We know what it takes to pool risk. And that does mean, Chuck, if they're pooling risk, that there are going to be claims likely during the year against their captive insurance company, correct?

Chuck Spitzer: That is exactly right. I mean, it is an insurance company, and insurance companies have claims. The co-claim scenario is a definite part of the proper construct of a captive insurance arrangement. We expect for there to be claims, claims that come through the risk pool and claims that are just paid specifically just by the client's insurance company for their operating company's claims. There's going to be both.

And we show the client how that works. Tom, as you know, on the front end, we show then exactly how all of the math works in a captive insurance arrangement, but yes, claims are important, not only just the fact that there are claims, but the fact that claims are handled similarly to how a big insurance company handles claims. In other words, it's not helter-skelter. There needs to be a claims adjudication process that is in place and is observed in the adjudication and payment of claims. That is another very important aspect of an insurance company that's going to qualify under section 831(b).

Tom Wheelwright:      One last point that I want to bring up here, and this is a question that a lot of people are going to have. Okay, so I put the money into this captive insurance. Let's say it's a million dollar premium, just for ease. I put this money into the captive. What happens to that money? Is there any kind of access to it, investment? What happens to that money? Does that money just sit there being an underutilized asset for years and years?

Chuck Spitzer: Absolutely not. When we establish these insurance companies, we file an investment policy statement that is part of the plan of operations that we file with the department of insurance, that allows the funds that are in that insurance company, the premium that it has received and capital that is placed in the insurance company, to be invested. As you might expect, it's an insurance company. It's subject to insurance regulations, so therefore, what I would characterize the investment policy statement to be is something that would call for a conservative allocation model. Stocks and bonds and treasuries and that sort of thing, all of a certain quality and all of a certain allocation mix.

So the money does not just sit idle. It can be invested and should be invested. I mean, if the client is really conservative, put it in CDs. That's fine as well. The one aspect of these little insurance companies that I should mention, Tom, is that for tax purposes, they are C corporations, so to the extent that they have investment income, it will pay tax on its investment income, but not on the premium that it receives, until there's a distribution of money out of the insurance company.

Tom Wheelwright:      Right, so we're talking about a 21% tax, which is not bad, I mean, when you consider that if you were to earn that personally, you'd probably pay a higher tax rate than that. So this is another tax benefit that we have. And I would just add that we've gone over really the basics of a captive insurance company. There's some pretty cool stuff we can do here. I mean, there's some stuff we can do from an estate planning standpoint, with other income tax. Understand, what I wanted to do here was I wanted to make sure that between Chuck and I we got out this idea that a captive insurance might be right for you.

Now, obviously, it's not cheap. You are sharing the risk premium. This is not something you do if you're in a 15% tax bracket. This is something you do when you're in the maximum tax bracket, and this is something that you do when your business is successful. And it's really one of those things that you look at and go, “Wow, I really do need insurance here.” I mean, I love, Chuck, that you talked about the gaps in insurance, because I've got to tell you, personally I have had the experience of a gap in insurance coverage that cost me a lot of money. It was simply that. It was a gap in insurance coverage, and it was actually a mistake made by our insurance broker, communication mistake. I'll blame it on the broker. The broker would probably blame it on me.

But in any case, there's gaps, and I love this idea that you are looking at the gaps, you're looking at what's not insured, you're looking at all the risks. There is a great tax benefit here, don't get me wrong, but that's not the reason to do this. If you're going to do a captive insurance, it's because you need the insurance. I would never recommend a captive for somebody who just wants a tax deduction. This is not a tax shelter. This is an insurance company, and this is real insurance. I've just found, though, that with our clients, that they really do have a lot of risks that are not covered, and it would be prohibitively expensive if they were to cover them in the traditional insurance market. Is that a fair statement, Chuck?

Chuck Spitzer: Absolutely, or in some cases, Tom, you can go to the Lloyd's market and insure anything you choose to insure, but it is very expensive to do so. So this is a great alternative for a client, and yes, you're exactly right, this is real insurance. It happens to have some very powerful economic benefits afforded to this whole idea, because of the Internal Revenue Code, but first it's an insurance company. It just happens to have some really nice economic benefits to it.

And Tom, I'd just also like to mention, and you know this, but we'll analyze a client's situation and determine whether or not it works for them or not. And you've had enough experiences with us to know that if we don't think it's right for them, we'll tell them so. We'll do an analysis for them and tell them yes or no, in terms of whether it makes sense for them, without them incurring one penny of cost. We will do that on our own nickel.

Tom Wheelwright:      And that's very important. Any time you hire a specialist in an area, whether it's captive or research and development credit or cost segregation, anything like that, they should be able to give you a pretty good estimate of whether this makes sense for you from a basically return on investment standpoint, and whether this will actually work for you. I always appreciate that about Chuck. Chuck, I appreciate your candor. Obviously, there's a lot we haven't covered, but at the same time, I just want people to understand, this is something.

Now, some of you will talk to your CPA, your CPA says, “Yes, but you have to disclose that on your tax return.” I'm going, “Yeah, so why not disclose it?” I mean, it's clear under the law. You know, it's like people are afraid of the home office deduction, because in some cases you have to disclose it. I'm going, “Well, why are you afraid of taking the deduction that's a legitimate deduction? Why are you afraid of something that is specifically allowed under the law?” That's where people lose tax benefits.

What really happens here, and Chuck, would you give us how we could find you? Anybody who wanted to find you, where would they go?

Chuck Spitzer: Well, we have a website, www.captiveinsuranceusa.com. My email address is cspitzer@captiveinsuranceusa.com. Or they can always call me directly on my number, which is 817-793-6522. Happy to visit with anyone who has an interest in learning more about this idea.

Tom Wheelwright:      Great. One thing I'll say about you, Chuck, is that you are the only advisor that I've ever sent a text to at 6:00 in the morning on a Saturday morning and got a call back five minutes later. That's one of the things I love about Chuck. You know, this is not unique to Chuck. I mean, there are other captive insurance companies out there that do a great job, so I just want to let everybody know, Chuck is the best at explaining it, and I love working with Chuck, because he can explain it. And any advisor you have should be able to explain it, and they can't explain it, then you have to wonder if they know what they're talking about.

Just once again, it's an opportunity for not all of you, but some of you, if a captive insurance company may make sense. And if you don't get in touch with Chuck, feel free to get in touch with us, and we can get you to Chuck as well, or even a number of captive insurance companies that you could talk to, just so that you get an idea of what's possible. Because when you do, when you do things like taking advantage of this tremendous tax incentive in the law, and at the same time you're considerably reducing your risk for your business, for your medical practice, for your real estate, whatever it is, you know what's going to happen. You're going to make way more money and pay way less taxes. We'll see you next time. 

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